Dollar on escalator and rupee on ventilator – why?

“In just seven months, from September 2007 to March 2008, the RBI bought an amazing sum of $70 billion — an average of $10 billion a month! This smashed the rupee on the rise, like the engine of an aircraft on take-off being turned off”

How come the dollar, which was in the ICU for the last six years and till August, is suddenly on the rise now?

“The government is concerned over the rapid appreciation of the rupee against the US dollar and the central bank may have to intervene if there is disorderly movement in the exchange rate.” This was the Finance Minister, Mr Palaniappan Chidambaram speaking in September 2007. The rupee was almost 41 to a dollar, on August 31, 2007.

A year earlier, on August 31, 2006, it was above Rs 46 to a greenback — meaning that the rupee had appreciated, or the dollar had depreciated, by 12 per cent in 12 months. That was why the Finance Minister had lost sleep.

Later, the rupee rose — the dollar fell — even further, spurning the RBI efforts to stop the rupee rise. By December 2007, a dollar cost far less, Rs 39.44; on January 20, 2008, it cost even less — Rs 39.30. But, now, in less than 10 months, the dollar costs almost Rs 50. So, the rupee has depreciated over 27 per cent since January this year. But now no one, not even the Finance Minister, seems to lose sleep over the sad state of the rupee.

But how come the dollar, which was in the ICU for the last six years and till August, is suddenly on the rise now? In Business Line (September 19, 2008) I had explained, that, from August 2008, the policy mechanics of G-7 nations, not market economics, had caused the dollar — which was sliding against almost all currencies for five years — to rise.

The European Union soon obliged the dollar by depreciating the Euro by 16 per cent against the greenback from August 2007. All talk of ‘market-decides-everything’ notwithstanding, the G-7 interventions in the market to reset currency values are no secret. The New York Times (October 25, 2008) cited at least two instances of such intervention. One, in 2000, the US Fed teamed up with the European Central Bank and the Bank of Japan to shore up the failing euro; another, during the Asian crisis in 1998, the US and other western nations teamed up to buy the falling Japanese yen.

Geopolitical decisions:

But now, why should other G-7 states lift the dollar when the US itself is sliding into what, many say, resembles the Great Depression of 1930s? There are two reasons. One, self interest. The other G-7 nations had large exposures in dollar-rated assets. They stood to lose if the dollar fell, and gain if it appreciated.

Second, general interest: the only way the cost of oil, priced in dollars by the OPEC, could be brought down was to raise the value of the dollar. So, with crude prices going through the roof in 2008, the G-7 nations perhaps felt justified in their decision to ensure that the dollar appreciated at the cost of their own currencies.

See how this geopolitical decision maimed the laws of market economics. The dollar had been on the ventilator for over five years. Its graph speaks for itself. From 2002 to March 2008, the dollar had lost 4/5 of its value in terms of the Euro; 2/5 against the British Pound; 1/3 against the Japanese Yen; 4/5 against the Canadian dollar; and 1/3 against the Singapore dollar.

It had lost 1/10 of its value even against the Indonesian Rupiah and 1/5 against the Malaysian Ringitt — both bankrupted in 1998. But how did the rupee fare against the dollar? For the year 2002-03, the rupee averaged above 47 to a dollar, and 44 for 2006-07 — registering a small decline of 7.8 per cent.

Thereafter, the dollar declined, and the rupee rose, faster. The rupee was just above 40 to a dollar in March 2008. Thus, the rupee saw a mere 15 per cent rise in the five years from 2002-03 to 2007-08. Why did the rupee not rise as much as other currencies did against the dollar, given India’s robust growth?

RBI intervention:

A few first principles to note here. One, the rupee is not fully convertible on capital account; two, therefore, the RBI has the power to intervene in the forex market; three, it does intervene. When the RBI intervenes to buy the dollar with the rupee, the greenback rises against the rupee. When the RBI sells the dollar for the rupee, the dollar falls against the rupee. But data show that the RBI mostly buys the dollar, rarely sells. The RBI buys dollars partly to augment forex reserves, and partly to maintain the exchange rate. Here’s a look at how the RBI had intervened in the forex market between 2002 and 2008.

In the four years from 2002-03 to 2005-06 the RBI had purchased $75 billion. When it was buying dollars here, the greenback was losing heavily in the global market. It had lost, in less than the three years ending 2004, in excess of 24 per cent against other major currencies and 60 per cent against the euro.

By March 2006, the RBI did double its forex fund to some $152 billion. But, in the next two years, 2006-07 and 2007-08, what happened needs to be seen in detail. For the first seven months up to October 2006, the RBI forex deals were minimal — it bought just $4.8 billion, less than $700 billion per month.

Suddenly, the RBI accelerated its dollar purchase by a factor of seven and bought $19.8 billion in the next four months to February 2007 — almost $5 billion a month! Had the RBI not done this, the globally depreciating dollar would have fallen below Rs 45 to a dollar. By this time, March 2007, the forex reserves had topped $199 billion.

Then came a brief, but decisive, u-turn. For the four months from March to June 2007, the RBI again moderated its dollar purchases to an average of $3 billion per month. Just a 40 per cent cut in the purchases from $5 billion a month to $3 billion a month.

The result was the fall of the dollar, and the rise of the rupee, from Rs 45 to a dollar in February to Rs 42 in April 2007, to less than Rs 41 in May, and almost Rs 40 in July.

Higher purchases:

The RBI, fearing a runaway rise of the rupee, again accelerated dollar purchases and bought, in July alone, $11.4 billion that equalled in one month the previous four months’ purchases. But even this would not stop the dollar from crashing below Rs 40 in August 2007, forcing the Finance Minister himself to voice concern at the rise of the rupee.

The result: in just seven months from September 2007 to March 2008, the RBI bought an amazing sum of $70 billion — an average of $10 billion a month! This smashed the rupee on the rise, like the engine of an aircraft on take-off being turned off.

In February 2008, the tide had turned against the rupee. With global oil prices moving from $100 to almost $150 in mid-2008, and the Indian oil companies having contracted huge sums of dollars, the rupee fell 10 per cent by August.

By then, the RBI had lost control over the rupee. The rupee dropped rapidly thereafter to almost Rs 50 to a dollar in October 2008 – a fall of 27 per cent in less than 10 months. A dollar which cost 1.599 euros on July 15, 2008 was lifted to 1.25 euros in October – a rise of 16 per cent in less than 100 days.

By September 2008, as the dollar was being wheeled out of the ICU, the rupee had been wheeled in. By October, the rupee, that had been riding the escalator till January, was on the ventilator, and the dollar, that had been on the ventilator till August, got on to the escalator.

Why did the RBI act the way it did? It had reasons to do what it did till June 2008, but not afterwards. Could India have avoided the rupee fall now? No. Could it have moderated its fall by better strategies, and sans politics? Yes.